Question

In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan were both concerned about a sluggish U.S. economy. They also were concerned about the large U.S. current account deficit. To help stimulate the economy, President Bush proposed a tax cut, while the Fed had been increasing U.S. money supply. Compare the effects of these two policies in terms of their implications for the current account. If policy makers are concerned about the current account deficit, discuss whether stimulatory fiscal policy or monetary policy makes more sense in this case. Then, reconsider similar issues for 2009–10, when the economy was in a deep slump, the Fed had taken interest rates to zero, and the Obama administration was arguing for larger fiscal stimulus. Why might many believe that the Fed should keep interest rates at near zero levels in 2016 and beyond as growth remains stagnant? ( explanation and graphs )

Answer 1

Tax cut will lead to increased spending as there will be increase in the disposable income of the workers . Rise in consumer spending will lead to rise in aggregate demand and thus leading to higher economic growth.Income tax cut may also increase incentive to work leading to higher productivity .Again when the Central bank increases the money supply in the economy , it encourages private consumption.Interest rate decreases when money supply is increased and this encourages lending and investment.Thus increase in consumption as well as investment leads to increase in AD which in turn lead to economi growth.

The US relies more on Federal reserves monetary policy to manage the economy but monetary policy is not suited to reduce current account deficit.Current account deficit means imports exceed exports .Monetary policy with its tools of open market operations, reserve requirement and discount rate ,can influence domestic prices,interest rates and output but is ineffective in dealing with the problem of current account deficit with flexible exchange rates.Fiscal policy with its tool of taxation and public spending can mange current account deficit.Most economists believe that the most effective way to reduce current account deficit is by reducing domestic spending by increasing national saving rate.Thus fiscal policy is more effective in reducing current account deficit.But many believe that both the policies have their own pros and cons and can be used effectively to reduce budget deficit.

When the economy is stagnant , Fed cuts interest rtaes to zero in an effort to encourage flow of credit to consumers and small businesses.Zero interest rate lower the cost of borrowing which helps in increasing spending on business capital,investments and household expenditures.Asset prices also increase when interest rate is zero.Thus the Fed lowers interest rate to stimulate economic growth as lower interest rate leads to borrowing and investing..